To SPAC or Not to SPAC?

Kristie P. Paskvan, CPA, MBA Board Director and Leadership Fellow
Strategies for Today's Corporate Finance Leaders

A headline in the New York Times caught my attention: “SPACs on Trial.” The article alleged that the founder of the zero-emissions truck company Nikola committed fraud by misleading investors with a video depicting a “Nikola One truck moving forward, while omitting the fact that the truck was rolling down an incline due to gravity rather than under its own power.” Nikola went public in June of 2020 via a SPAC named VectorIQ.

While the Manhattan U.S. attorney’s office wasn’t objecting to the SPAC structure itself, the article highlights the level of scrutiny that every SPAC will experience following their proliferation and domination of the initial public offering (IPO) space during the last 18 months. Private companies and their boards looking to go public will need to weigh the benefits of a SPAC offering versus the risk of bypassing the more rigorous traditional IPO process.

An Overview of SPACs

SPACs, otherwise known as “blank check companies,” have been around since the early 1990s and hold no operating assets. In the beginning, SPACs mostly benefited industry insiders, didn’t have many protections, and thus had a somewhat suspect reputation. But their reputation was partially rehabilitated when the New York Stock Exchange (NYSE) and Nasdaq started listing SPACs and the SEC added new oversight.

The general process for a SPAC today is as follows: The SPAC files an IPO with the SEC to raise capital, usually at $10 per share, with the specific purpose of acquiring or merging with a private operating company within a specified timeframe and taking that company public. The various parties that manage the SPAC are identified as the “sponsors” in documents, and are generally industry insiders—private equity or hedge fund firms with fundraising expertise. The SPAC files the required documents, but since it’s a shell entity, there are no audited financials for investors to review. Investors instead base their interest in investing in the SPAC on the sponsors’ experience and the industries or companies the SPAC may target with the capital it raises—although the SPAC is not strictly held to that criteria. Want to invest in space travel, electric flying vehicles, or online gaming? There’s a SPAC for that. Examples of high-profile companies that have gone the SPAC route are Virgin Galactic, Lucid Motors, and DraftKings.

As part of the SPAC’s IPO, warrants may be issued to its investors. A warrant is a contract that gives the holder the right to purchase a certain number of shares of common stock in the future at a certain price, often at a premium to the issuance price. Proceeds from the fundraising (generally at least 90 percent) go into a trust to be held until the SPAC’s targeted acquisition or merger occurs. According to Ohlrogge and Klausner’s study of recent SPACs, a typical SPAC holds just $6.67 per share in cash of its original $10 IPO price by the time it enters into a merger agreement with its target company.

The usual time frame for a SPAC to identify and close an acquisition or merger is two years, although some prospectuses indicate 18 months. The sponsor team also typically receives a 20 percent ownership stake in the acquired company, known as the “promote,” for no or minimal fees.

In 2020, SPACs accounted for 53 percent of all IPOs. In the first half of 2021, that percentage rose to 59 percent according to SPAC Alpha. And according to SPAC Analytics, the number of SPAC IPOs skyrocketed from 46 in 2018 and 59 in 2019 to a staggering 248 in 2020 and 388 as of June 2021, with the proceeds growing apace–SPACs have raised $116 billion in funds so far in 2021 to deploy within two years. This is an enormous amount of money available to take private companies public via the SPAC process. While SPAC activity has decreased as of the writing of this article, it’ll be interesting to see what happens to the private company marketplace over the next few years, given the number of SPACs created in the last year and the funds available to take private companies public.

The Benefits of SPACs

What accounts for the increase in SPAC IPOs, especially when the typical risk and financial analysis isn’t available during the IPO period?

• SPACs often take public a startup or technology company that doesn’t have a long history of profits, if any, and may not have the same ability as more established entities to withstand an IPO roadshow.
• The number of public companies listed on the NYSE and Nasdaq has decreased over time from over 8,000 in the 1990s to around 6,000 now, sending investors and exchanges alike looking for additional investment opportunities.
• As retail investment increases through platforms like Robinhood, SPACs provide the ability to access IPO activity not previously available to the typical retail investor until after a company has gone public.
• Private equity funds not only have funds available for investing, but also have companies in prior investment portfolios that they’re ready to sell to SPACs.
• Shares in a SPAC are liquid, and an investor can cash out if they don’t like the proposed target.
• Going public via a SPAC is faster and cheaper than the traditional IPO process, making it attractive to both sponsors and investors.

SPAC Scrutiny 

The SEC has become more involved in regulating SPACs, setting a fixed IPO price for the offering, regulating voting and redemption, and warning investors not to invest in SPACs solely because of a celebrity endorsement, noting the potential lack of business acumen.

Proskauer Rose’s analysis of SPAC activity from 2016 through 2020 notes the total number of days to complete a deal in 2020 averaged 265—159 days to sign a letter of intent and 106 days to close. They also noted that the recent SEC guidance on SPAC warrants may increase the average number of days to identify and close a transaction.

In April, the SEC indicated that the warrants issued to investors at all levels should be considered a liability on the balance sheet instead of equity. Accounting firms are also evaluating and discussing the attributes required to characterize the warrants issued in future transactions as equity, while closed SPAC entities are reviewing recent treatment at closing.

While due diligence is completed by the sponsor group on the acquisition or merger company target, it falls far short of what’s required in a traditional IPO. And while the SPAC process is faster, it raises substantial concerns about the quality of the information. It’s unclear what fiduciary responsibility the sponsors assume for that information if difficulties arise. A few years ago, WeWork was unable to complete its traditional IPO process because of questions about its operating model and proposed valuation—the company subsequently went the SPAC route.

Litigation has also increased dramatically. According to information from Cornerstone Research and Stanford Law School’s Securities Class Action Clearinghouse, 14 federal suits were brought against SPACs in the first half of 2021. SPACs have also not performed well post-IPO in the marketplace. Two-thirds of the 36 U.S. companies to have gone public after Jan. 1, 2019 via U.S. SPACs that Bloomberg Law analyzed have reported a loss in value. More broadly, the Wall Street Journal reported in early September that a widespread selloff has wiped 25 percent, or approximately $75 billion, off the combined market value of a group of 137 SPACs that closed mergers by mid-February—the pullback topped $100 billion at one point.

So, while private companies may find it irresistible to go public via SPACs to avoid submitting themselves to the costs, delays, and scrutiny of a traditional IPO through the major exchanges, I caution that boards of directors and management teams have fiduciary obligations to uphold, and they should carefully weigh the risks versus the rewards of undertaking this accelerated process.